Coverage of the 2016 Risk Management Conference

Since 2008, equity volatility has prompted plan sponsors to consider de-risking strategies in an effort to get away from the roller-coaster movements of markets. But where does that volatility come from – and is there a way to understand how equities move in relation to different parts of the economic cycle? Nelson Yu, portfolio manager and head of quantitative research, equities, AB, believes it’s possible – but it’s a matter of style.

Yu considers the basic style boxes investors tend to think about when looking at returns: large-, mid- and small-cap, as well as value, core value and growth. While these factors are well known among investors, less is known about how each performs in a shifting economy. For example, notes Yu, during times of economic or geopolitical volatility, which factors would under- or outperform?

Through his own analysis, Yu has been able to break down the performance of specific factors based on economic cycles – rising and falling economic growth and interest rates. “As economic growth starts to take hold,” Yu says, “the economy shifts into an expansionary period and rates start rising.” Further into the cycle, rising interest rates can moderate economic growth. As we move into economic contraction, interest rates fall again.

Understanding the cycle

And so the cycle continues – with a direct impact on factors. By using the Purchasing Managers Index, a key indicator of the economic health of the manufacturing sector, Yu shows how factors perform during different cycles – and maps them according to period.

During times of recovery, Yu explains, cyclical value and small cap did the best, while the low risk factor did best during periods of economic contraction. Growth did best during periods of expansion while growth and quality both did well during periods of moderation. Economic slowdowns send investors running to safety as they seek companies with a higher and more stable levels of probability, Yu says.

The question is, how can investors apply this to portfolio construction? Yu applies his model to MSCI factor indices to show which ones are more or less correlated during different cycles. “The MSCI Value factor has the most correlation with the recovery period of the economic cycle,” he explains. The MSCI USA Growth Index is negatively correlated to cyclical value. It does poorly in the recovery, but starts doing well as economic growth takes told in expansion and moderation, just as the Value Index works less well.

In the end, it’s all about the cycles – understanding which factors do what during each point is key to outperformance and, ultimately, equities allocations.